Blockchain in the Capital Markets: A Solution Looking for a Problem?

Blockchain in the Capital Markets: A Solution Looking for a Problem?

Posted on Thu, Jun 14, 2018 @ 8:00

By Tim Williams, Colt Technology Services Originally published on the TabbFORUM

Late last year, the Australian Stock Exchange confirmed it was using blockchain technology for its clearing and settlement. The talk last year was all about finding a use case for distributed ledger technology – essentially trying to find a problem to fit the solution. Does ASX’s announcement mean that the blockchain has finally found a home in the capital markets?

Late last year, the Australian Stock Exchange (ASX) confirmed that it was using blockchain technology for its clearing and settlement, arguably becoming the first capital markets firm to use distributed ledger technology (DLT) at scale in the real world.

The talk last year was all about finding a use case for DLT – essentially trying to find a problem to fit the solution. Does ASX’s announcement mean that the blockchain has finally found a home in the capital markets?

Can we ever have a truly distributed DLT?

Traditionally, clearing and settlement has been taken care of by central counterparty clearing houses (CCPs) and other regulated, centralized infrastructures. DLTs have the potential to disrupt this system, reducing the need for these platforms and replacing them with a decentralized, distributed ledger.

This ledger would replicate “the blockchain in the Bitcoin sense” and would act as a homogenous, cross-border financial exchange through which all markets activity flows. Without transactions having to run through multiple systems and via several parties, such a model could mean significant cost-savings, greater efficiency, increased trust and more transparency for market participants.

If anything, clearing and settlement might be the most obvious place for DLT. After all, it’s almost a like-for-like swap in terms of functionality; but there are other innovative ways in which the technology is being experimented with. NASDAQ recently filed a patent for recording asset ownership, CME has filed a patent for setting up and executing futures contract,s and Australia’s Commonwealth Bank is planning a bond offering using DLT later this year.

However, one thing these applications have in common is that they are not “The Blockchain” in the bitcoin sense – a cross-industry, widely distributed system. And it’s unlikely that we’ll see this anytime soon. Living up to that promise and replicating this across the traditional financial markets would be difficult to set up, manage and regulate. Perhaps the biggest question mark is around how it would be paid for. If managed by a single company, the industry loses the trust of a decentralized, independent platform. If managed by a large number of different companies, it would be next to impossible to engineer a coordinated effort. Each commercial entity is likely to want different things from the solution and so a consensus is unlikely.

Blockchain with a small ‘b’

Instead, the true proliferation of DLT may come through closed systems, focused on a specific, specialized use and managed by a single entity for use by its clients. Although details have been scant, this seems to be the modus operandi of the members of R3, the (as-was) consortium of banks and tech companies researching possible DLT uses for the capital markets.

Single instance uses provide many of the benefits without the negotiations and political wrangling necessary for a wider network. What these single instance use cases are will take some exploring, but it’s immediately obvious that DLT lends itself to applications that aren’t latency sensitive, are administrative in nature and are broadly repetitive – effectively, back-office operations (as ASX has shown) that need to be auditable and can be automated.

The potential for this technology is certainly powerful, and it is bound to disrupt various aspects of the capital markets, including post-trade processing. But the issue here is, if we’re not talking about a homogenous, multinational system, then we’re likely not capitalizing on the efficiency and transparency that blockchain promises. And, to that end, it remains unclear how much this would improve on the existing system we have in place.

Finding the right fit for DLT

The benefits of DLT aside, if it is to work in the real world, it needs to be in real time. Or as close to real time as possible. Currently, the Bitcoin Blockchain can take hours to update due to the sheer number of participants. If a DLT-based system is to succeed, it needs to be an improvement over current infrastructure, and in some cases this bar is lower than in others. Clearing and settlement, for example, is batch-based and occurs once daily. On the other hand, using DLT for real-time trade reporting for high-frequency trading firms may not be so simple. Clearly, the drop-in processing speed that comes with increased scale means that DLT is perhaps more suitable where accuracy is preferred over speed.

So it’s clear that blockchain may not be the solution to all problems and is still, in many ways, very much a technology looking to solve a problem. But while the future for DLT is unclear, it’s far from dull. There are myriad processes, both on the buy and sell side, that can be replaced by this technology, and a future where blockchains (rather than “The Blockchain”) are at the heart of the capital markets is a real possibility.